Renewables: The way forward

At a time when oil prices have risen dramatically, Jonathan Johns, head of renewable energy at Ernst & Young looks at whether or not the Renewables Obligation Review (RO) is fulfilling its role as part of the UK's climate change strategy, and opportunities to improve its effectiveness.

The Renewables Obligation (RO) has transformed the sector and, in the wind industry at least, led to a greatly invigorated development industry. The RO's predecessors - the Non Fossil Fuel Obligation and the Scottish Renewables Order - have a patchy track record, delivering around 1,450MW of operational plant between 1990 and 1 April 2002. This compares to over 1,500MW of new capacity coming online in the first three years of the RO's implementation. The pace is likely to accelerate considerably.

Key issuesThe further deployment of renewable energy is dependent on maintaining an attractive and stable investment environment. The RO mechanism is working and changes that would upset investor confidence in the scheme should be avoided. Bank credit committee confidence depends on stability above everything else. Therefore, even changes which may seem logical may upset the confidence of lenders if they are perceived as increasing the political risk associated with renewable energy investment - particularly retrospective changes that affect the value of assets. The announcement by Malcolm Wicks, Minister for Energy in June that NFFO 3, 4 and 5 projects will qualify for Renewables Obligation Certificates (ROC)'s after their expiry, is very welcome in this regard.

The extension of the RO targets beyond 2015, even if only modestly above the current level of 15%, is also crucial for investor confidence. Due to the lack of longer-term commitment to the support of renewable energy, financiers' lending to projects to begin construction in the next few years have to charge a risk premium on loan life beyond 2015. This issue is especially true for offshore wind, the success of which is crucial to the achievement of the UK's targets.

Some projects are at make or break point in terms of investment and project viability, particularly as second round projects do not benefit from the capital grants available in the second round.

There are a number of areas where the RO could be enhanced to improve investor confidence:

1: The obligation contains an inherent bias against independent developers who are reliant on bank finance. As such transactions are dependent on long term PPAs from credit worthy suppliers. These PPA's have been subject to large discounts to reflect the regulatory risk in terms that go beyond the 2015 time horizon. Increasing the targets to 20%, for example, in 2020 with a commitment to extend the scheme annually, even if only by a modest amount, would notably improve project economics for independent developers.

2: Some PPA providers require substantial letters of credit from generators to cover the risk of ROC revocation. The changes suggested elsewhere in the paper are important to alleviate this need and the associated cost.

3: A commitment to grandfather rights to ensure they survive any change in legislation is needed, so that minimum benefits are preserved in any successor regime (it is acknowledged that this may be difficult to achieve from a legislative standpoint).

4: The extension of ROC support to the biomass fraction of RDF/SRF for energy from waste may be justifiable. It is recognised that any change should not undermine the market for ROC's. Consequently, an alternative mechanism to help the sector may be preferred. The interaction between the need for waste minimisation and the possibility for power generation needs further review.

6: New technologies - such as wave and tidal - find it difficult to be viable under the ROC regime. They require extra ROCs in the early stages of their development or other forms of support such as capital grants (the Scottish Executive plans for 1 for 2 ROCs for wave and tidal are particularly unclear in this regard).

The UK ranks high in Ernst & Young's Renewable Energy Country Attractiveness Index. However, this position is not a birthright and action is required to ensure that it is sustained. Ernst & Young's new set of indices - The Near-Term Index, highlights the challenge.

Under the Near-Term Index - which looks at market attractiveness over a two-year period - the UK is ranked at number five and trails behind countries such as Spain, the US, Germany and India (see table below). This is because the markets are forecast to install in excess of 1GW to December 2006 compared to the 500 to 750 mega watts (MW) anticipated in the UK, due to drift in the project timetables in the offshore and Scottish onshore markets.

Country

Near-Term Rank

Combined Near-Term wind score

Near-Term onshore wind score

Near-Term offshore wind score

Spain

1

84

84

-

USA

2

78

78

-

Germany

3

75

72

68

India

4

61

61

-

UK

5

60

53

87

The Near-Term Index reveals the danger of a gap between the 'promise and reality' in the UK's renewable energy market. In the next two years the UK needs to deliver MW's both on the ground and in the sea. As the US flexes its market power, manufacturer's attention and time is being diverted at a period when capacity is constrained. Further impetus is therefore vital for the UK market as some projects find that production slots are shifted to larger US projects.

If the economics for second round offshore are not improved, then some key projects may face difficulties gaining investment sanction. Post Katrina, the attitude of the US government towards Climate Change could well move towards stronger federal or state incentives, thus increasing the pressure on the UK to remain competitive as a magnet for inward investment.

By Johnathan Johns, Head of Renewables at Ernst & Young.

About the IndexThe Ernst & Young Country Attractiveness Indices provide scores for national renewable energy markets, renewable energy infrastructures and their suitability for individual technologies. The indices provide scores out of 100 and are updated on a regular basis. The main indices will now be referred to as the 'Long-Term Index'. The newly added Near-Term Index takes a two-year view with slightly different parameters and weightings (see below). The Country Attractiveness Indices take a generic view and different sponsor/financier requirements will clearly effect how countries are rated. Ernst & Young's Renewable Energy Group can provide tailor made studies to meet specific corporate objectives.

About Ernst & YoungErnst & Young, a global leader in professional services, is committed to restoring the public's trust in professional services firms and in the quality of financial reporting. Its 100,000 people in 140 countries pursue the highest levels of integrity, quality, and professionalism in providing a range of sophisticated services centered on our core competencies of auditing, accounting, tax, and transactions. Further information about Ernst & Young and its approach to a variety of business issues can be found at www.ey.com/perspectives. Ernst & Young refers to all the members of the global Ernst & Young organization.